Tuesday, August 8, 2017

When Will the Tech Bubble Burst?

Ruchir Sharma, author of “The Rise and Fall of Nations: Forces of Change in the Post-Crisis World,” and chief global strategist at Morgan Stanley Investment Management, wrote an op-ed for the New York Times, When Will the Tech Bubble Burst?:

At the height of a market mania in 1967, the author George Goodman captured the mood perfectly, comparing it to a surreal party that ends only when “black horsemen” burst through the doors and cut down all the revelers who remain. “Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time. So everybody keeps asking — what time is it? But none of the clocks have hands.”

Every decade since, the global markets have relived this party. In the late 1960s the mania was for the “nifty 50” American companies like Disney and McDonald’s, which had been the “go-go” stocks of that decade. In the late 1970s it was for natural resources, from gold to oil. In the late 1980s it was stocks in Japan, and in the late 1990s it was the dot-com boom. Last decade, investors flocked to mortgage-backed securities and big emerging markets from Brazil to Russia. In every case, many partygoers were still in the market when the crash came.

Today, tech mania is resurgent. Investors are again glancing at a clock with no hands — and dismissing the risk. The profitless start-ups that were wiped out in the dot-com crash have consolidated into an oligopoly composed of leading survivors such as Google and Apple. These are giants with real earnings, yet signs of an irrational euphoria are growing.

One is pitchmen bundling investments with very different outlooks into a single package. Last decade they bundled Brazil, Russia, India and China to sell as the BRICs. More recently they packaged Facebook, Amazon, Netflix and Google as FANG, then, as names and prospects shifted, subbed in Alphabet, Apple and Microsoft to make Faama. Others are hyping the hottest tech companies in China as BAT, for Baidu, Alibaba and Tencent. Whatever the mix, acronym mania is usually a sign of bubbly thinking.

Seven of the world’s 10 most valuable companies are in the tech sector, matching the late 1999 peak. As the American stock market keeps marching to new highs — the Dow hit 22,000 this week — the gains are increasingly concentrated in the big tech stocks. The bulls say it is inevitable that Apple will become the first trillion-dollar company.No matter how surreal the endgame, booms tend to begin with real innovation. In the past, manias have been triggered by excitement about canals, the telegraph and the automobile. But not since the advent of railroads incited market booms in the 1830s and 1840s has the world seen back-to-back booms like the dot-com bubble of the 1990s and the one we are in now.

The dot-com era saw the rise of big companies that were building the nuts and bolts of the internet — including Dell, Microsoft, Cisco and Intel — and of start-ups that promised to tap its revolutionary potential. The current boom lacks a popular name because the innovations — from the internet of things to artificial intelligence and machine learning — are sprawling and hard to label. If there is a single thread, it is the expanding capacity to harness data, which the Alibaba founder, Jack Ma, calls the “electricity of the 21st century.”

Market excitement about authentic technology innovations enters the manic phase when stock prices rise faster than justified by underlying economic growth. Since the crisis of 2008, the United States economy has been recovering at the rate of around 2 percent, roughly half the rate seen for much of the past century. The areas of growth are limited in this environment. Oil’s not very euphoric, with prices depressed, while regulators are forcing banks to keep the music down. In the most direct echo of 1999, technology is once again seen as the best party in town.

It is true that prices today are not quite as widely overvalued as in 1999. Large technology stocks are up 350 percent this decade, the low end of the range for the hot stocks from earlier booms, which saw gains of 300 to 1,900 percent. Only a few select technology companies — mainly the internet giants — are trading close to the valuations of the dot-com era, when the average price-to-earnings ratio for tech companies hit 50. The average ratio for that sector today is 18.

However, the scale of today’s tech boom is not readily visible because much of the investment action has moved into the hands of big private players. In 1999, nearly 550 start-ups went public, and after many ended in disaster, the government tightened regulation of public companies. In part to avoid that red tape, this year only 11 tech companies have gone public. Many are raising money instead from venture capitalists or private equity funds. Venture capitalists have poured more than $60 billion into the technology sector every year for the past three years — the highest flows since the peak in 2000 — and private equity investors say there has never been a better time to raise money.

These new private funding channels are creating “unicorns,” companies that haven’t gone public but are valued at $1 billion or more. Unicorns barely existed in 1999. Now there are more than 260 worldwide, with technology companies dominating the list. And if signs emerge that the privately owned unicorns are faltering, the value of publicly owned tech companies is not likely to hold up either.

We can never know when the end will come. Still, there are three critical signals to watch for.

The first is regulation. The tech giants are seen today as monopolizing internet search and commerce, and they are angling to take over industries such as publishing and automobiles, raising alarms at antitrust agencies in Europe and the United States. Fear that new internet technologies are doing more to waste time and brainpower than to increase productivity has already provoked a backlash in China, where officials recently criticized online gaming as “electronic heroin.” A regulatory crackdown on tech giants as either monopolies or productivity destroyers could pop the allure of tech stocks.

The other signals are more familiar. Going back to the “nifty 50” stocks of the 1960s, nearly every big market mania ended after central banks tightened monetary policy and many people who had borrowed to get in the game found themselves in trouble. The dot-com bubble peaked in 2000, after the Federal Reserve had increased interest rates multiple times. The current boom will likewise be at risk if an increase in inflation compels the Fed to raise interest rates beyond the modest rise the market currently expects.

Finally, watch for tech earnings to start falling short of analyst forecasts. The dot-com boom was driven in part by increasingly optimistic predictions for technology company earnings, and it imploded when earnings started to miss badly. Investors realized then that their expectations about profits from the internet revolution had become unreal.

Of course, no two booms will unfold exactly the same way. We are now eight years into this bull market, making it the second longest in history, behind only the run-up of the late 1990s. No bull market lasts forever, and while it is clear that we are entering the late stages of this cycle, it is impossible to say whether this moment is like 1999, or 1998 — or earlier.

The clocks have no hands, and the black horsemen may appear at any time.

It makes me nervous when I see the chief global strategist at Morgan Stanley write an op-ed pondering when the tech bubble will crash.

Why? Simply because typically bubbles go on a lot longer after some strategist writes these articles in a major newspaper, a lot longer.

There are two big risks in the market right now:

A major correction or even a meltdown unlike anything we have seen before as literally every risk asset is way overvalued.

A 1999-2000 melt-up where stocks go parabolic led by tech giants and biotech, forcing fund managers to keep buying at higher multiples or risk severe underperformance.

Risk managers often focus on the first risk but neglect the second one which is much more painful because it can last a lot longer than fund managers can stay solvent.

No doubt, 2008 was very painful, I remember it like yesterday when the Dow was falling 400, 500 or 700 points a day. It was beyond scary and I don't want to minimize the psychological effects of a severe meltdown.

But what about the risks of stocks continuing to grind higher? I'm not going to lie to you, that risk is in the back of my head too at the time of writing this comment, and it's something I lived back in 1999-2000 when you'd wake up and see tech stocks up 10, 20 or 30 percent a day every single day!

It was relentless, like a giant steamroller eviscerating short sellers and leaving many value managers scratching their head asking whether there is a new paradigm in markets.

The problem with these melt-up rallies is they're led by huge liquidity. That's what happened back in 1999-2000 and it took several rate hikes before that tech bubble burst.

But now we have even more liquidity in the system as central banks around the world slashed rates to near zero and engaged in unprecedented quantitative easing.

In other words, it could take a lot of time for this liquidity party to dry up so don't be surprised if stocks continue making record gains, frustrating fund managers who don't want to indiscriminately buy at these high valuations.

"But Leo, with rates near zero, it's a no-brainer, just buy more stocks as record low rates justify these valuations in tech stocks and in dividend stocks which have also run up a lot."

I guess there is an argument to be made that record low rates justify these valuations (the so-called Fed model of stocks) but I always begin my analysis with macro fundamentals, and they're not good.

The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.

Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.

Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.

Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.

These are the six structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

Now, let me take a little detour here to teach people some very basic macro points which everyone seems to get wrong:

First, in an ultra low interest rate world, currency swings matter a lot. Why? When the US dollar takes a hit relative to the euro and yen, like it did since December, this means the euro and yen strengthen, which means tighter financial conditions and lower import prices in these regions as they are effectively importing deflation. The problem is Japan is stuck in deflation and the Eurozone isn't far behind (never mind the rosy headlines proclaiming deflation risk is removed in Europe, that's utter nonsense). In other words, given the deflationary headwinds in Japan and the Eurozone, they can't afford to see their currencies appreciate for a long period, it only reinforces more deflation at a time when they're desperately trying to escape it.

Second, and more importantly, the US leads the world. When the US economy is slowing -- and make no mistake, despite Friday's good jobs report, it is slowing -- it leads the rest of the world by six to nine months. So expect the US dollar (UUP) to rally relative to other currencies even if the Fed takes a pause from raising rates. Why? Because as the world ex-US slows, real rate differentials widen, making the US dollar that much more attractive. And if there is a full-blown financial crisis, then the flight-to-liquidity will support US bonds (TLT) and the dollar.

Third, as the US dollar gains relative to other currencies, US import prices will fall as the US imports global deflation. The threat then becomes a full-blown dollar crisis which I warned of late last year (it hasn't happened yet) and deflation coming to America which I discussed three years ago.

Lastly, and equally important, talk of a bond bubble is just silly in a deflationary environment. Legions of hedge funds shorting JGBs in the 90s got wiped off the planet and legions of hedge funds shorting US Treasurys now and in the future will suffer the same fate.

In a deflationary environment, I remain long US long bonds (TLT) and the US dollar (UUP) and short cyclical risk assets, including energy, commodities, emerging market stocks, bonds and currencies and commodity currencies.

I tell all my friends and family to use the strength in the loonie to buy US assets now, particularly US long bonds (TLT) which will rally as long bond yields make a new secular low. Moreover, they will gain more as the US dollar gains on the Canadian dollar over the next year(s).

Why US bonds? Why not US or Canadian dividend stocks? Because their valuations are high and there's too much beta embedded in them.

More importantly, if a crisis hits us, only US long bonds will offer you the ultimate diversification and protect your portfolio from being obliterated.

I'm astounded at how many financial advisors and institutional investors just don't get it and buy the garbage that global growth is strong and inflation will roar back.

Now, getting back to Ruchir Sharma's comment, he cites inflation and the risks of the Fed raising rates as one of the three factors that will spell the end of this tech bubble.

He's out to lunch and I won't mince my words here. It's not inflation stupid, it's deflation and plunging rates whch will spell the end of the current tech and non-tech bubble. Period, end of story.

"But Leo, plunging rates are always good for stocks and home prices, right?" Wrong, wrong, wrong! Not when they are due to debt deflation and high unemployment, then plunging rates won't counteract the deadly effects of deflation, they will only reinforce them.

Folks, Ruchir Sharma is asking the wrong question. It's not when the tech bubble will burst, it's when will deflation come to America and obliterate all risks assets for a very, very long time.

You see, when the next crisis hits us, risk assets will get clobbered and stay low for a lot longer than even pessimists warn of. It will be a generational shift, unlike anything we've ever seen before.

There will be no more buying FANG stocks at whatever multiple, what I'm talking about is a crisis in capitalism, unlike anything we have ever lived through in the developed world.

"Leo, stop, you're scaring me with this Marxist doomsday talk." Alright, I'll stop here but there are limits to inequality and at one point, high structural unemployment and rising inequality fueled by rising pension poverty will threaten social democracies as we know them.

But for now, enjoy the tech bubble as tech stocks like Nvidia (NVDA) keep making record highs (click on image):

Just remember the laws of gravity apply to stocks too, and when macro winds turn south, tech high-flyers will get crushed.

On that note, Michael Kantrowitz at Cornerstone Macro put out a comment and video earlier today on why stocks are skating on thin ice this summer. Take the time to listen to him, he explains why the huge rally in large cap growth is not a good sign for the future.

Again, I recently put all my money in US long bonds (TLT) because while I made great money trading biotech (XBI) stocks in the first half of the year, I fear these high-beta high-flyers will get killed too when the next beta tsunami hits us.

I've been sleeping like a baby ever since I stopped trading biotech stocks but sometimes I get the urge to nimble here and there when I see moves like Fibrogen and other biotech stocks I track closely (click on image):

Still, while I like biotechs (XBI) a lot even in a deflationary world (they have pricing power), I need to remain disciplined and focused and let my macro views dictate my risk-taking behavior.

And right now, I see huge deflationary risks in the world which is why I truly believe US long bonds (TLT) offer investors the best risk-adjusted returns over the next year or longer and will prove to be the ultimate diversifier, protecting your portfolio from being obliterated as deflation roils all risk assets.

Let me end my comment by thanking those of you who take the time to donate and subscribe to my blog. I truly appreciate it and sincerely thank you for your support.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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